11/29/2001 @ 9:17AM

While Enron Burned, Wall Street Fiddled

Answer: An Enron is a company that markets electricity and natural gas, delivers energy and other physical commodities, and provides financial and risk management services.

Next question: Delivering energy, that’s good. But what’s all this about marketing electricity and “risk management services?”

Answer: Good question, can we get back to you? But first let’s talk about the numbers: Enron has great numbers.

This was essentially the dialogue between Wall Street and Enron
investors for the past few years, at least until yesterday when the
Dynegy
pulled its offer to buy the company. Enron was involved in barely understood activities–mostly under the rubric of trading energy–and reported its results in mysterious ways, but it announced larger and larger revenue with each passing quarter. The modus operandi was: Ask no questions and we’ll tell no lies.

Enron
Special Report: Is Enron Out Of Gas?
But Wall Street knew one thing: Enron made its numbers and the numbers were beautiful. In the four quarters of 2000, Enron reported sales of $13 billion, $16 billion, $30 billion and $41 billion. In the past four years, its revenue grew fivefold from $20 billion to $101 billion.*

It grew by inventing and then dominating the energy trading business, still a relatively recent phenomenon. Other trading companies–Wall Street firms like Goldman Sachs
, Merrill Lynch
, Morgan Stanley
or Lehman Brothers
–rarely trade at more than 20 times earnings. But Enron, based in Houston, at one time traded as high as roughly 70 times earnings.

The celestial valuation may seem to have been justified by the booming revenue. But profits were growing at a much more ordinary rate. Enron’s net income grew mightily after a down year in 1997, but then it inched up from $1.01 per share in 1998 to $1.12 per share in 2000. This profit growth is using the old numbers–before Enron was forced to restate its profit and loss statement earlier this month.

Meanwhile, the share price (adjusted) climbed from $19 at the beginning of 1997 to $82 at the end of 2000.

If Enron’s profits were less spectacular and largely based on an increasing volume of paper transactions, not actual delivery of oil or gas, its story was quite good. Enron would do for telecommunications what it had done already for energy; it would get into “broadband” and the Internet; it would team with
Blockbuster
and deliver movies on demand. While its achievements were real, the fantasy is what sold.

Major Wall Street analysts listened intently to the story and few questioned it. As of last month, 13 analysts covered the company. Eleven recommended it as a “buy” or “strong buy.” Just one said “sell” and the other said “hold.” This was just one week before the roof fell in, and Enron announced it would sell itself to Dynegy, its crosstown rival.

But the Dynegy deal has collapsed, its main business has shut down, and Enron seems likely to file for bankruptcy. How did it all collapse so quickly? Even when
Jeffrey
Skilling
Jeffrey Skilling
, the company’s chief executive officer, resigned in August for “personal reasons” after just six months at the helm, no one on Wall Street responded to the red flag. Like other Enron executives, Skilling had exercised millions in stock options and sold shares while the company was flying high.

In October, the company disclosed $1 billion in writedowns and a $1.2 billion reduction in shareholder equity. The reduction in equity arose from “related party” transactions that turned out to be with investment partnerships involving Chief Financial Officer Andrew Fastow and other Enron executives. The debt issued by these partnerships, it turned out, was really Enron’s. Fastow was forced to resign on Oct. 24. Enron’s new disclosure itself left a lot of questions.

For Enron, the crisis snowballed. “The problem with Enron is their trading operation needed credibility to sustain itself,” says Sean Egan, a managing director of Egan-Jones Ratings. “People will not make trades with a firm with significant credit problems.” The partnerships owed as much as $6 billion, Egan says, which the company had not disclosed.

Christopher Ellinghaus, an analyst at Williams Capital Group, who covers Dynegy, but not Enron, says the principal business was sound and the revenue was real. But “the fundamental business was built on trust, like Wall Street.” Enron’s secondary businesses like trading broadband and its international energy business never did well. The collapse of the share price undermined the value of Enron’s collateral and its ability to borrow, he says.

Enron’s last straw came when the major debt rating agencies downgraded it debt to junk status. This new designation meant that much of the money Enron borrowed was due right away, causing an even greater credit crisis. It is one of the most spectacular corporate flameouts in U.S. history.

Egan faults the Moody’s Investors Service and Standard & Poor’s rating agencies for being slow to discover Enron’s real debt load and knock down its investment grade rating. He says the agencies were “coopted” partly by Enron but mostly by banks like J.P. Morgan Chase
and Citigroup
, who pressured the agencies to delay their downgrade so Enron could find a buyer.

Now Enron faces waves of lawsuits and a U.S. Securities and Exchange Commission investigation. Criminal indictments are a real possibility. A criminal investigation might lead to calls for a special prosecutor with wide-ranging power in the manner of Kenneth Starr. This is because
Kenneth
Lay
Kenneth Lay
, Enron’s most recent CEO and chairman, is a friend of U.S. President
George W.
Bush
George W. Bush
and Vice President
Dick
Cheney
Dick Cheney
.

One of the first questions investigators will ask is what did Skilling know and when did he know it.

What happened at Enron is “difficult to do without a lot of people at the top knowing about it,” says John Baker, who teaches energy business strategy at the Rice School of Management in Houston. If Skilling knew when he resigned and said nothing, that “looks strange. It was certainly not the right thing to do by any stretch of the imagination.”

* A previous version of this story incorrectly referred to Enron’s sales figures in millions of dollars.